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OP-ED: Review That Buy-Sell Agreement Before Trouble Pops Up

December 27, 2018

Overview

A buy-sell agreement (also known as a shareholder agreement) plays an important role in maintaining alignment between ownership and a business’ objectives. However, businesses too often fail to appreciate the importance of these agreements until problems arise. Common problems include failing to follow the terms of the agreement, failing to regularly review and update the agreement to ensure it continues to meet business objectives, and creating an agreement based on unrealistic assumptions. The following is a list of some common issues that arise with buy-sell agreements:

Mandatory redemptions

Some buy-sell agreements include provisions that require the company to buy out an owner in certain circumstances, such as death or termination of employment. The problem with such provisions is that they create a financial obligation on the company that may arise without warning or at a time when the company lacks the liquidity to honor the obligations. The alternative to a mandatory redemption is an optional buyout right. Under that approach, the company has an option, but not an obligation, to buy out the owner following the triggering event (i.e., death or termination of employment).

Pricing formulas

When a buy-sell agreement requires or allows the company to purchase equity from an owner following certain triggering events, the agreement needs to provide a method for valuing the equity. Many agreements use a formula for establishing the price. While formulas are easy to apply and avoid the cost of an appraisal, they often get the valuation wrong. When that occurs, it often leads to disputes between the company and the selling owner. Businesses can reduce this risk by regularly reviewing the formula being used to calculate the valuation of their equity and making updates as needed.

Regulatory requirements

Many small businesses, including construction and architecture firms, elect S-corporation tax status. Maintaining S-corporation status depends, in part, on limiting ownership only to those allowed under the regulations governing S-corporations. A buy-sell agreement should include provisions voiding any attempted transfer of equity that would invalidate the S-corporation election. Similarly, certain professional firms are subject to limitations on their ownership by the rules governing their profession. For example, OAR 806-010-0080(5)(c) requires architects or engineers registered in any National Council of Architectural Registration Boards (NCARB) recognized jurisdiction to own at least two-thirds of the ownership interest in any limited liability company operating as an architectural firm. A buy-sell agreement should include provisions prohibiting transfers of equity that would cause the professional firm to violate any regulatory requirements applicable to its profession.

Restrictive covenants

Buy-sell agreements provide an opportunity for the owners of the business to reach a collective agreement that they will not compete against the business, solicit customers or hire employees. Such restrictions avoid much of the scrutiny applicable to similar arrangements between employers and employees if drafted properly. For example, these restrictions should tie back to ownership in the business, not the owner’s status as an employee of the business.

Rights of contribution

Many lenders and bonding companies require personal guaranties from the owners of a business owning more than a small percentage of it. In these situations, the owners who provided the personal guaranty may want to add a right of contribution provision in the buy-sell agreement. A contribution provision allows the guarantying owners a right to seek pro rata payments from the non-guarantying owners if they are ever required to make payments on the guaranty issued to the lender or bonding company.

Tax distributions

Many small businesses are structured as pass-through entities for tax purposes (S-corporations and most limited liability companies). For such entities, the taxable income of the business is recognized on the owners’ personal tax returns. To help ensure that such owners have the cash needed to pay the tax liability arising from the company’s taxable income, most buy-sell agreements include a provision requiring the business to make a cash distribution sufficient for the owners to pay the tax liabilities attributed to them from the business’ operations.

Legends

Stock certificates and any similar certificate evidencing ownership should include a legend noting that the equity represented by the certificate is subject to transfer restrictions set forth in the buy-sell agreement. Such legends may prove critical in a company’s ability to enforce the terms of the buy-sell agreement against a party that acquired the equity without knowledge of the existence of the agreement.

Spousal consents

Buy-sell agreements should include a spousal consent to address community property issues that can arise when an owner is married and lives in a community property state (such as Washington or California). While most buy-sell agreements require spousal consents, many companies forget to obtain them. Companies are encouraged to periodically review changes in the marital status or home address of their owners and seek spousal consent as appropriate.

The foregoing items are not an exhaustive list of the issues that may be relevant to a company and its owners. However, they do illustrate the importance of reviewing the terms of a buy-sell agreement on a regular basis to ensure that it continues to meet the needs of the business.